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Environmental Analysis : Strategically relevant components of internal and external environment, Industry and
completive analysis, analysis of resources and competitive capabilities, environmental scanning techniques
University Questions
1. What is the rationale of understanding a SWOT analysis? Explain.
2. Discuss the Industry attractiveness-business strength matrix and its relationship to the current

corporate scenario.
Explain Value chain analysis? What are its strength and weaknesses?
Discuss the relevance of value chain analysis and its application to strategy formulation.
Discuss Industry analysis and explain how it is different from internal analysis.
Explain the issue probability matrix.
Explain the purpose of doing competitor analysis. Explain how porters five force model affects
industry structure.
Discuss the importance of gathering competitive intelligence.
Discuss the important forecasting tools used in strategic management process.

1. What is the rationale of understanding a SWOT analysis? Explain.
The Three Steps of SWOT Analysis: Identify, Draw Conclusions, Translate Into Strategic Action, shows the three steps of
SWOT analysis.
Just what story the SWOT analysis tells about the companys overall situation can be summarized in a series of questions:
a. Does the company have an attractive set of resource strengths?
b. How serious are the companys weaknesses and competitive deficiencies?
c. Do the companys resource strengths and competitive capabilities outweigh its resource weaknesses and competitive
deficiencies by an attractive margin?
d. Does the company have attractive market opportunities that are well suited to its resource strengths and competitive
e. Are the threats alarming or are they something the company appears able to deal with and defend against?

How strong is the companys overall situation?

Implications for SWOT analysis for strategic action:

a. Which competitive capabilities need to be strengthened immediately?
b. What actions should be taken to reduce the companys competitive liabilities?
c. Which market opportunities should be top priority in future strategic initiatives? Which opportunities should be ignored?
d. What should the company be doing to guard against the threats to its well-being?
A companys resource strengths should generally form the cornerstones of strategy because they represent the companys best
chance for market success.

Sound strategy making requires sifting thorough the available market opportunities and aiming strategy at capturing those that
are most attractive and suited to the companys circumstances.

2.Discuss the Industry attractiveness-business strength matrix and its relationship to the current
corporate scenario.

Using a Nine-Cell Matrix to Simultaneously Portray Industry Attractiveness and Competitive Strength: The industry
attractiveness and business strength scores can be used to portray the strategic positions of each business in a diversified
company. Industry attractiveness is plotted on the vertical axis and competitive strength on the horizontal axis. A nine-cell grid
emerges from dividing the vertical axis into three regions and the horizontal axis into three regions. Figure 9.5, A Nine-Cell
Industry Attractiveness-Competitive Strength Matrix, depicts this tool. Each business unit is plotted on the nine-cell matrix
according to its overall attractiveness score and strength score and then shown as a bubble. The location of the business units
on the attractiveness-strength matrix provides valuable guidance in deploying corporate resources to the various business
units. In general, a diversified companys prospects for good overall performance are enhanced by concentrating corporate
resources and strategic attention on those business units having the greatest competitive strength and positioned in highly
attractive industries.
CORE CONCEPT: In a diversified company, businesses having the greatest competitive strength and positioned in
attractive industries should generally have top priority in allocating corporate resources.
The nine-cell attractiveness-strength matrix provides clear, strong logic for why a diversified company needs to consider both
the industry attractiveness and business strength in allocating resources and investment capital to its different businesses.
3. Explain Value chain analysis? What are its strength and weaknesses?
4. Discuss the relevance of value chain analysis and its application to strategy formulation.
A.The Concept of a Companys Value Chain
1. A companys value chain consists of the linked set of value-creating activities the company performs internally.
CORE CONCEPT: A companys value chain identifies the primary activities that create customer value and the related
support activities.
2. Figure 4.3, A Representative Company Value Chain, depicts the linked set of value creating activities.
3. The value chain consists of two broad categories of activities:
a. Primary activities: foremost in creating value for customers

b. Support activities: facilitate and enhance the performance of primary activities

4. Disaggregating a companys operations into primary and secondary activities exposes the major elements of the companys
cost structure.
5. The combined costs of all of the various activities in a companys value chain define the companys internal cost structure.
6. The tasks of value chain analysis and benchmarking are to develop the data for comparing a companys costs, activity by
activity, against the costs of key rivals and to learn which internal activities are a source of cost advantage or disadvantage.
B. Why the Value Chains of Rival Companies Often Differ
1. A companys value chain and the manner in which it performs each activity reflect the evolution of its own particular business
and internal operations, its strategy, the approaches it is using to execute its strategy, and the underlying economics of the
activities themselves.
2. Because these factors differ from company to company, the value chain of rival companies sometimes differ substantially a
condition that complicates the task of assessing rivals relative cost positions.
C. The Value Chain System for an Entire Industry
1. Accurately assessing a companys competitiveness in end-use markets requires that company managers understand the entire
value chain system for delivering a product or service to end-users, not just the companys own value chain.
2. A Representative Value Chain for an Entire Industry, explores a value chain for an entire industry.
CORE CONCEPT: A companys cost competitiveness depends not only on the costs of internally performed activities
(its own value chain) but also on costs in the value chain of its suppliers and forward channel allies.
3. Suppliers value chains are relevant because suppliers perform activities and incur costs in creating and delivering the
purchased inputs used in a companys own value chain.
4. Forward channel and customer value chains are relevant because:
a. The costs and margins of a companys distribution allies are part of the price the end user pays
b. The activities that distribution allies perform affect the end users satisfaction
5. Actual value chains vary by industry and by company. Generic value chains like those in Figures 3.3 and 3.4 are illustrative,
not absolute and have to be drawn to fit the activities of a particular company or industry.
D. Developing the Data to Measure a Companys Cost Competitiveness
1. The next step in evaluating a companys cost competitiveness involves disaggregating or breaking down departmental cost
accounting data into the costs of performing specific activities.
2. A good guideline is to develop separate cost estimates for activities having different economics and for activities representing
a significant or growing proportion to cost.
Traditional accounting identifies costs according to broad categories of expense. A newer method,
activity-based costing, entails defining expense categories according to the specific activities being
performed and then assigning costs to the activity responsible for creating the cost.

5. Discuss Industry analysis and explain how it is different from internal analysis.
An industry analysis is a business function completed by business owners and other individuals to assess the current business
environment. This analysis helps businesses understand various economic pieces of the marketplace and how these various pieces
may be used to gain a competitive advantage. Although business owners may conduct an industry analysis according to their
specific needs, a few basic standards exist for conducting this important business function

Industry analysis enables a company to develop a competitive strategy that best defends against the competitive forces or
influences them in its favour. The key to developing a competitive strategy is to understand the sources of the competitive
forces. By developing an understanding of these competitive forces, the company is able to:

highlight the companys critical strengths and weaknesses (SWOT analysis)

animate its position in the industry

clarify areas where strategic changes will result in the greatest payoffs

emphasize areas where industry trends indicate the greatest significance as either opportunities or threats

Industry analysis and structure

The five competitive forces reflect the fact that competition within an industry extends beyond current competitors.
Customers, suppliers, substitutes and potential entrantscollectively referred to as an extended rivalryare competitors to
companies within an industry. The five competitive forces jointly determine the strength of industry competition and
profitability. The strongest force (or forces) rule and should be the focal point of any industry analysis and resulting
competitive strategy.

Short-term factors that affect competition and profitability should be distinguished from the competitive forces that form
the underlying structure of an industry. Although these short-term factors may have some tactical significance, analysis
should focus on the industrys underlying characteristics
Internal Analysis
A review of an organization's strengths and weaknesses that focuses on those factors within its domain. A detailed internal analysis will typically give a
business a good sense of its basic competencies and the desirable improvements that it can make to help meet the requirements of potential customers

within its intended market

Industry analysis is more focus on Opportunities and threats and Internal analysis is concerned on
strengths and weaknesses.
6. Explain the issue probability matrix

Probability of Occurrence

Probable Impact on Corporation













Other Tech. are










7. Explain the purpose of doing competitor analysis. Explain how porters five force model affects
industry structure

What Kinds of Competitive Forces are Industry Members Facing?

1. The character, mix, and subtleties of the competitive forces operating in a companys industry are never the same from one
industry to another.
2. The most powerful and widely used tool for systematically diagnosing the principal competitive pressures in a market and
assessing the strength and importance of each is the five-forces model of competition.
3. The Five-Forces Model of Competition: A Key Tool for Diagnosing the Competitive Environment, depicts this tool.

4. This model holds that the state of competition in an industry is a composite of competitive pressures operating in five areas of
the overall market:
a. Competitive pressures associated with the market maneuvering and jockeying for buyer patronage that goes on among
rival sellers in the industry
b. Competitive pressures associated with the threat of new entrants into the market
c. Competitive pressures coming from the attempts of companies in other industries to win buyers over to their own
substitute products
d. Competitive pressures stemming from supplier bargaining power and supplier-seller collaboration
e. Competitive pressures stemming from buyer bargaining power and seller-buyer collaboration
5. The way one uses the five-forces model to determine what competition is like in a given industry is to build the picture of
competition in three steps:
a. Step One: Identify the specific competitive pressures associated with each of the five forces
b. Step Two: Evaluate how strong the pressures comprising each of the five forces are (fierce, strong, moderate to normal, or
c. Step Three: Determine whether the collective strength of the five competitive forces is conducive to earning attractive
A. The Rivalry Among Competing Sellers
1. The strongest of the five competitive forces is nearly always the rivalry among competing sellers the marketing maneuvering
and jockeying for buyer patronage that continually go on.
2. In effect, a market is a competitive battlefield where it is customary and expected that rival sellers will employ whatever
resources and weapons they have in their business arsenal to improve their market positions and performance.
CORE CONCEPT: Competitive jockeying among industry rivals is ever changing, as fresh offensive and defensive
moves are initiated and rivals emphasize first one mix of competitive weapons and tactics then another.
3. Figure 3.4, Weapons for Competing and Factors Affecting the Strength of Rivalry, shows a sampling of competitive
weapons that firms can deploy in battling rivals and indicates the factors that influence the intensity of their rivalry.
4. A brief discussion of some of the factors that influence the tempo of rivalry among industry competitors is in order:
a. Rivalry among competing sellers intensifies the more frequently and more aggressively that industry members undertake
fresh actions to boost their market standing and performance, perhaps at the expense of rivals
5. Other indicators of the intensity of rivalry among industry members include:

a. Whether industry members are racing to offer better performance features or higher quality or improved customer service
or a wider product selection
b. How frequently rivals resort to such marketing tactics as special sales promotions, heavy advertising, or rebates or low
interest rate financing to drum up additional sales
c. How actively industry members are pursuing efforts to build stronger dealer networks or establish positions in foreign
markets or otherwise expand their distribution capabilities and market presence
d. The frequency with which rivals introduce new and improved products
e. How hard companies are striving to gain a market edge over rivals by developing valuable expertise and capabilities
6. Normally, industry members are proactive in drawing upon their competitive arsenal of weapons and deploying their
organizational resources in a manner calculated to strengthen their market position and performance.
7. Additional factors that influence the tempo of rivalry among industry competitors include:
a. Rivalry is usually stronger in slow-growing markets and weaker in fast-growing markets
b. Rivalry intensifies as the number of competitors increases and as competitors become more equal in size and capability
c. Rivalry is usually weaker in industries comprised of so many rivals that the impact of any one companys actions is spread
thinly across all industry members, likewise, it is often weak when there are fewer than five competitors
d. Rivalry increases as the products of rival sellers become more standardized
e. Rivalry increases as it becomes less costly for buyers to switch brands

Rivalry is more intense when industry conditions tempt competitors to use price cuts or other competitive weapons to
boost unit volumes

g. Rivalry increases when one or more competitors become dissatisfied with their market position and launch moves to
bolster their standing at the expense of rivals
h. Rivalry increases in proportion to the size of the payoff from a successful strategic move

Rivalry becomes more volatile and unpredictable as the diversity of competitors increases in terms of visions, strategic
intents, objectives, strategies, resources, and countries of origin


Rivalry increases when strong companies outside acquire weak firms in the industry and launch aggressive, well-funded
moves to transform their newly acquired competitors into major market contenders

k. A powerful, successful competitive strategy employed by one company greatly intensifies the competitive pressures on its
rivals to develop effective strategic responses or be relegated to also-ran status
8. Rivalry can be characterized as:
a. Cutthroat or brutal when competitors engage in protracted price wars or habitually employ other aggressive tactics that
are mutually destructive to profitability
b. Fierce to strong when the battle for market share is so vigorous that the profit margins of most industry members are
squeezed to bare bones levels
c. Moderate or normal when the maneuvering among industry members still allows most members to earn acceptable
d. Weak when most companies are relatively well satisfied with their sales growth and market shares, rarely undertake
offensive maneuvers to steal customers away from one another, and have comparatively attractive earnings and returns on
B. The Potential Entry of New Competitors
1. Several factors affect the strength of the competitive threats of potential entry in a particular industry.
2. Figure 3.5, Factors Affecting the Strength of Threat of Entry, identifies several factors that affect how strong the
competitive threat of potential entry is in a particular industry.
3. One factor relates to the size of the pool of likely entry candidates and the resources at their command. As a rule, competitive
pressures intensify as the pool of entry candidates increases in size.
4. Frequently, the strongest competitive pressures associated with potential entry come not from outsiders but from current
industry participants looking for growth opportunities.

5. Existing industry members are often strong candidates to enter market segments or geographic areas where they currently do
not have a market presence.
6. A second factor concerns whether the likely entry candidates face high or low entry barriers. The most widely encountered
barriers that entry candidates must hurdle include:
a. The presence of sizable economies of scale in production or other areas of operation When incumbent companies enjoy
cost advantages associated with large-scale operation, outsiders must either enter on a large scale or accept a cost
disadvantage and consequently lower profitability.
b. Cost and resource disadvantages not related to size Existing firms may have low unit costs as a result of experience or
learning-curve effects, key patents, partnerships with the best and cheapest suppliers of raw materials and components,
proprietary technology know-how not readily available to newcomers, favorable locations, and low fixed costs.
c. Brand preferences and customer loyalty In some industries, buyers are strongly attached to established brands.
d. Capital requirements The larger the total dollar investment needed to enter the market successfully, the more limited the
pool of potential entrants.
e. Access to distribution channels In consumer goods industries, a potential entrant may face the barrier of gaining
adequate access to consumers.

Regulatory policies Government agencies can limit or even bar entry by requiring licenses and patents.

g. Tariffs and international trade restrictions National governments commonly use tariffs and trade restrictions to raise
entry barriers for foreign firms and protect domestic producers from outside competition.
7. Whether an industrys entry barriers ought to be considered high or low and how hard it is for new entrants to compete on a
level playing field depend on the resources and competencies possessed by the pool of potential entrants.
8. In evaluating the potential threat of entry, company mangers must look at:
a. How formidable the entry barriers are for each type of potential entrant
b. How attractive the growth and profit prospects are for new entrants
CORE CONCEPT: The threat of entry is stronger when entry barriers are low, when there is a sizable pool of entry
candidates, when industry growth is rapid and profit potentials are high, and when incumbent firms are unable or
unwilling to vigorously contest a newcomers entry.
9. Rapidly growing market demand and high potential profits act as magnets, motivating potential entrants to commit the
resources needed to hurdle entry barriers.
10. The best test of whether potential entry is a strong or weak competitive force in the marketplace is to ask if the industrys
growth and profit prospects are strongly attractive to potential entry candidates.
11. The stronger the threat of entry, the more that incumbent firms are driven to seek ways to fortify their positions against
newcomers, pursuing strategic moves to not only protect their market shares, but also make entry more costly or difficult.
12. The threat of entry changes as the industrys prospects grow brighter or dimmer and as entry barriers rise or fall.
C. Competitive Pressures from the Sellers of Substitute Products
1. Companies in one industry come under competitive pressure from the actions of companies in a closely adjoining industry
whenever buyers view the products of the two industries as good substitutes.
2. Just how strong the competitive pressures are from sellers of substitute products depends on three factors:
a. Whether substitutes are readily available and attractively priced
b. Whether buyers view the substitutes as being comparable or better in terms of quality, performance, and other relevant
c. How much it costs end-users to switch to substitutes
3. Figure 3.6, Factors Affecting Competition from Substitute Products, lists factors affecting the strength of competitive
pressures from substitute products and signs that indicate substitutes are a strong competitive force.
4. The presence of readily available and attractively priced substitutes create competitive pressure by placing a ceiling on the
prices industry members can charge without giving customers an incentive to switch to substitutes and risking sales erosion.
5. The availability of substitutes inevitably invites customers to compare performance, features, ease of use, and other attributes
as well as price.

6. The strength of competition from substitutes is significantly influenced by how difficult or costly it is for the industrys
customers to switch to a substitute.
7. As a rule, the lower the price of substitutes, the higher their quality and performance, and the lower the users switching costs,
the more intense the competitive pressures posed by substitute products.
8. Good indicators of the competitive strength of substitute products are the rate at which their sales and profits are growing, the
market inroads they are making, and their plans for expanding production capacity.
D. Competitive Pressures Stemming from Supplier Bargaining Power and Supplier-Seller Collaboration
1. Whether supplier-seller relationships represent a weak or strong competitive force depends on:
a. Whether the major suppliers can exercise sufficient bargaining power to influence the terms and conditions of supply in
their favor
b. The nature and extent of supplier-seller collaboration
2. How Supplier Bargaining Power Can Create Competitive Pressures: When the major suppliers to an industry have
considerable leverage in determining the terms and conditions of the item they are supplying, they are in a position to exert
competitive pressures on one or more rival sellers.
3. The factors that determine whether any of the suppliers to an industry are in a position to exert substantial bargaining power or
leverage are fairly clear-cut:
a. Whether the item being supplied is a commodity that is readily available from many suppliers at the going market price
b. Whether a few large suppliers are the primary sources of a particular item
c. Whether it is difficult or costly for industry members to switch their purchases from one supplier to another or to switch to
attractive substitute inputs
d. Whether certain needed inputs are in short supply
e. Whether certain suppliers provide a differentiated input that enhances the performance or quality of the industrys product

Whether certain suppliers provide equipment or services that deliver valuable cost-saving efficiencies to industry members
in operating their production processes

g. Whether suppliers provide an item that accounts for a sizable fraction of the costs of the industrys product
h. Whether industry members are major customers of suppliers

Whether it makes good economic sense for industry members to integrate backward and self-manufacture items they have
been buying from suppliers

4. Figure 3.7, Factors Affecting the Bargaining Power of Suppliers, summarizes the conditions that tend to make supplier
bargaining power strong or weak.
5. How Seller-Supplier Partnerships Can Create Competitive Pressures: In more and more industries, sellers are forging
strategic partnerships with select suppliers in efforts to reduce inventory and logistics costs, speed the availability of next
generation components, enhance the quality of the parts and components being supplied and reduce defect rates, and squeeze
out important cost-savings for both themselves and their suppliers.
6. The many benefits of effective seller-supplier collaboration can translate into competitive advantage for industry members
who do the best job of managing supply chain relationships.
7. The more opportunities that exist for win-win efforts between a company and its suppliers, the less their relationship is
characterized by who has the upper hand in bargaining with the other.
E. Competitive Pressures Stemming from Buyer Bargaining Power and Seller-Buyer Collaboration
1. Whether seller-buyer relationships represent a weak or strong competitive force depends on:
a. Whether some or many of the buyers have sufficient bargaining leverage to obtain price concessions and other favorable
terms and conditions of sale
b. The extent and competitive importance of seller-buyer strategic partnerships in the industry
2. How Buyer Bargaining Power Can Create Competitive Pressures: The leverage that certain types of buyers have in
negotiating favorable terms can range from weak to strong.
3. Even if buyers do not purchase in large quantities or offer a seller important market exposure or prestige, they gain a degree of
bargaining leverage in the following circumstances:

a. If buyers costs of switching to competing brands or substitutes are relatively low Buyers who can readily switch brands
or source from several sellers have more negotiating leverage than buyers who have high switching costs.
b. If the number of buyers is small or if a customer is particularly important to a seller The smaller the number of buyers,
the less easy it is for sellers to find alternative buyers when a customer is lost to a competitor.
c. If buyer demand is weak and sellers are scrambling to secure additional sales of their products Weak or declining
demand creates a buyers market and shifts bargaining power to buyers.
d. If buyers are well-informed about sellers products, prices, and costs The more information buyers have, the better
bargaining position they are in.
e. If buyers pose a credible threat of integrating backward into the business of sellers Companies like Anheuser-Busch,
Coors, and Heinz have integrated backward into metal-can manufacturing to gain bargaining power in obtaining the
balance of their can requirements from otherwise powerful metal-can manufacturers.

If buyers have discretion in whether and when they purchase the product If consumers are unhappy with the present
deals offered on major appliances, hot tubs, home entertainment centers, or other goods for which time is not a critical
purchase factor, they may be in a position to delay purchase until prices and financing terms improve.

4. Figure 3.8, Factors Affecting the Bargaining Power of Buyers, summarizes the circumstances that make for strong or weak
bargaining power on the part of buyers.
5. Not all buyers of an industrys product have equal degrees of bargaining power with sellers and some may be less sensitive
than others to price, quality, or service differences.
6. How Seller-Buyer Partnerships Can Create Competitive Pressures: Partnerships between sellers and buyers are an
increasingly important element of the competitive picture in business-to-business relationships as opposed to business-toconsumer relationships.
F. Determining Whether the Collective Strength of the Five Competitive Forces is Conducive to Good Profitability
1. Scrutinizing each competitive force one by one provides a powerful diagnosis of what competition is like in a given market.
2. Does the State of Competition Promote Profitability? As a rule, the stronger the collective impact of the five competitive
forces, the lower the combined profitability of industry participants.
CORE CONCEPT: The stronger the forces of competition, the harder it becomes for industry members to earn
attractive profits.
3. The most extreme case of a competitively unattractive industry is when all five forces are producing strong competitive
pressures. Fierce to strong competitive pressures coming from all five directions nearly always drive industry profitability to
unacceptably low levels, frequently producing losses for many industry members and forcing some out of business. Intense
competitive pressures from just two or three of the five forces may suffice to destroy the conditions for good profitability and
prompt some companies to exit the business.
4. In contrast, when the collective impact of the five competitive forces is moderate to weak, an industry is competitively
attractive in the sense that industry members can reasonably expect to earn good profits and a nice return on investment.
5. The ideal competitive environment for earning superior profits is one in which both suppliers and customers are in weak
bargaining positions, there are no good substitutes, high barriers block further entry, and rivalry among present sellers
generates only moderate competitive pressures.
6. Does Company Strategy Match Competitive Conditions? Working through the five-forces model step-by-step not only
aides strategy makers in assessing whether the intensity of competition allows good profitability but it also promotes sound
strategic thinking about how to better match company strategy to the specific competitive character of the marketplace.
7. Effectively matching a companys strategy to the particular competitive pressures and competitive conditions that exist has
two aspects:
a. Pursuing avenues that shield the firm from as many of the prevailing competitive pressures as possible
b. Initiating actions calculated to produce sustainable competitive advantage, thereby shifting competition in the companys
favor, putting added competitive pressure on rivals, and perhaps even defining the business model for the industry
CORE CONCEPT: A companys strategy is increasingly effective the more it provides some insulation from
competitive pressures and shifts the competitive battle in the companys favor.
VI. Question 3: What Factors are Driving Industry Change and What Impacts Will They Have?

1. An industrys present conditions do not necessarily reveal much about the strategically relevant ways in which the industry
environment is changing.
2. All industries are characterized by trends and new developments that gradually or speedily produce changes important enough
to require a strategic response from participating firms.
3. The popular hypothesis that industries go through a life cycle of takeoff, rapid growth, early maturity, market saturation, and
stagnation or decline helps explain industry change but it is far from complete.
A. The Concept of Driving Forces
1. Although it is important to judge what growth stage an industry is in, there is more analytical value in identifying the specific
factors causing fundamental industry and competitive adjustments.
2. Industry and competitive conditions change because certain forces are enticing or pressuring industry participants to alter their
3. Driving forces are those that have the biggest influence on what kinds of changes will take place in the industrys structure
and competitive environment.
4. Driving forces analysis has two steps:
a. Identifying what the driving forces are
b. Assessing the impact they will have on the industry
Industry conditions change because important forces are driving industry participants (competitors, customers, or suppliers) to alter
their actions; the driving forces in an industry are the major underlying causes of changing industry and competitive conditions some
driving forces originate in the macro-environment and some originate from within a companys immediate industry and competive

8. Discuss the importance of gathering competitive intelligence

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9. Discuss the important forecasting tools used in strategic management process

Subjective versus Objective Methods

Subjective methods are those in which the processes used to analyze the data have not
been well specified. These are also called implicit, informal, clinical, or intuitive methods. They
may be based on simple or complex processes. They may use objective data or subjective data as
inputs. Subjective methods may be supported by much formal analysis or by none. But the
critical point is that the analyst makes the forecast in his or her head. For example, executives
could be asked to make annual forecasts of automobile sales for the next five years. They would
be provided with any information they request, but they would produce the final forecasts by
Objective methods are those that use well-specified processes to analyze the data. Ideally,
they have been specified so well that other analysts can replicate them and obtain identical
forecasts. These are also called explicit, statistical, or formal methods. They may be based on
simple or complex processes. They may use objective data or subjective data as inputs. They
may be supported by much formal analysis or none. But the critical factor is that the inputs are
translated into forecasts using a process that can be replicated by other analysts. Furthermore, the
forecasting process could be programmed on the computer. An example would be an
econometric model to forecast industry automobile sales.
The choice between subjective and objective methods is an important one. Most forecasts
are made using subjective methods (Rothe, 1978). It also seems that the more important the
forecast, the greater is the likelihood that subjective methods will be used. (But the popularity of
a method is a poor guide in determining which method is most useful.)

Naive versus Causal Methods

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Linear versus Classification Methods

Methods that are objective and that rely upon causality can be categorized according to
whether they use linear or classification methods. This decision generally has only a small
impact on accuracy. It depends mostly upon convenience and the availability of data
(classification methods typically require much data).
The linear method is based upon the usual way we think about causality: If X goes up,
this will cause Y to go up by so much. An attempt is made to find linear relationships between
X and Y. Linear methods are used because it is easier to work with models where the terms can
be combined by using simple arithmetical operations. Thus, one might try to predict automobile
sales by fo recasting changes in income and price, and then multiplying by the relationships of
these factors to auto sales.
The classification approach groups similar behavioral units. These groups or segments
would be expected to respond in a similar fashion. For example, to forecast automobile sales, one
segment might be family size of two, age of head of household 65 to 75, low income, living in
apartment in a large city, near mass transportation. Another segment might be family size of
five, age of head of household 25 to 35, high income, living in house in a suburb, not near mass
transportation. The people within each segment would be expected to have similar behavior
with respect to the purchase of automobiles, but the segments differ substantially from one
another (low automobile purchases in the first group and high in the second group). To make a
prediction using the classification method, forecasts would be made of the population of each
segment and also of their behavior. These are then combined to get a forecast of auto sales for
each segment. By summing across segments, an overall forecast is obtained (for example, total
industry sales). The classification approach is most useful when the groups differ substantially
from one another.

The Methodology Tree

The methodology tree (Figure 2-3) is used to summarize the above discussion on the
choice of a forecasting method. The first decision to be made is whether it is most appropriate to
use a subjective or objective method. The subjective branch leads to the judgment leaf. An
extension of this is called bootstrapping. This involves the development of an objective
method to replicate the judgmental forecasts. This can be done by asking the judges to specify
the rules they used to make forecasts. Alternatively, one can statistically analyze the judgmental
forecasts and the data used by the judges to infer what rules were used. The bootstrapping model
can then be used to make the forecasts.
The objective branch offers a number of approaches to forecasting. One must decide
whether it is most appropriate to use naive or causal methods. The naive branch leads to the
extrapolation method.


Use of the causal branch requires an additional decision. Should you use linear or
classification methods? The linear branch leads to econometric methods and the classification
branch leads to segmentation methods.
The thickness of the branches of the methodology tree indicates which decisions are most
important in the selection of a forecasting method. The leaves of the tree (boxes) can be used
as a checklist for selecting 3r method.
The methods will be discussed in a somewhat more detailed fashion below. For a more
in-depth description, many sources exist (e.g., Wood and Fildes, 1976; Wheelwright and
Makridakis, 1980).


Formal forecasting methods help to improve planning in two ways. First, they can
increase accuracy over what would occur with informal methods and, thus, reduce uncertainty.
Second, they can provide better estimates of the degree of uncertainty (risk).
Improved accuracy and better estimates of risk are needed for various Phases of the
forecasting and planning processes. These needs are described below, starting with the
environmental forecast.